Fat bonuses don’t work

We’ve heard quite a bit about the new ‘two-strikes’ rule on executive pay in the media since an amendment to the Corporations Act, to toughen executive remuneration conditions, was passed in July.  This amendment was the outcome of a Productivity Commission inquiry into executive remuneration released in January this year.

While more accountability to shareholders is a positive move I hope that shareholders exercising their votes to force changes in the level and structure of executive pay are aware of the recent research into the effectiveness of bonuses on performance, which may run counter to their intuition.  Indeed, large performance bonuses are not always effective incentives.

First, here’s how the Senate’s explanatory memorandum describes the amendment:

This reform strengthens the non-binding vote and maintains the fundamental principle underlying Australia’s corporate governance framework that directors are responsible for, and accountable to, shareholders on all aspects of the management of the company, including amount and composition of executive remuneration.

That seems fair enough, but let’s take a closer look at how shareholder accountability will play out in practice:

Where a company’s remuneration report receives a `no’ vote of 25 per cent or more, the company’s subsequent remuneration report must explain the board’s proposed action in response or, if the board does not propose any action, the board’s reasons for inaction [Schedule 1, Item 19, paragraph300A(1)(g)]; and

Where the company’s subsequent remuneration report receives a `no’ vote of 25 per cent or more, a resolution must be put (known as the `spill resolution’) to shareholders at the same AGM. Notice of the spill resolution must be contained in the meeting papers for the AGM to ensure that notice has been given in the event that the second strike is triggered.

The notice must explain the circumstances in which the resolution will apply. [Schedule 1, Item 9, subsection 249L(2)]

If the spill resolution passes with 50 per cent or more of the eligible votes cast, another meeting of the company’s shareholders (known as the `spill meeting’) must be held within 90 days [Schedule 1, Item 13, section 250V]. A company will still need to provide the minimum notice period for holding a meeting, as required by the Corporations Act. A company will also need to comply with any minimum notice period set out in its constitution for the nomination of candidates for the board. This will ensure that shareholder nominated candidates can seek endorsement at the spill meeting [Schedule 1, Item 13, section 250W].

The separation of the `second strike’ and the `spill resolution’ is intended to ensure that shareholders are not discouraged from voting against the remuneration report, because they fear removal of certain board members. It ensures that shareholders are free to express their concerns on the remuneration report, and is intended to provide a clearer signal of shareholders’ views on the remuneration report.

In sum, the board has two chances to get shareholders on board with their remuneration structure or risk being voted out at the spill resolution.

One interesting feature of the amendment is that hedging of incentive payments for key management personnel will be prohibited.  This improves on the 2007 amendment to the Corporations Act that required disclosure of company policy on hedging and enforcement mechanisms.  There are a few other tweaks, including regulations around the appointment of remuneration consultants, voting on remunerations by key management personnel who themselves are subject to the report, and more.

Tightening legislative restrictions of executive remuneration is part of a global movement – shareholders ‘Occupying the Boardroom’ you might call it (as discussed here):

The tougher Australian laws parallel similar moves in the Netherlands, Norway, Sweden and the United Kingdom which have responded to public outrage about executive pay levels.

The US has also introduced similar legislation effective from the 2011 proxy season in the wake of public concern about the role of excessive remuneration in the global financial crisis.

Executives aren’t happy.

James Packer’s Crown saw a 50per cent vote against the executive remuneration package, and lashed out to shareholders saying “If we receive a second strike again next year we will be left in the farcical position of the board being subject to a spill. If that happens I will use my votes to ensure all directors are voted back in immediately”.

After receiving a more than 25 per cent ‘no’ votes, Watpac Chairman Kevin Seymour apparently ‘unleashed a torrent of abuse’ against the rule, although his formal remarks were fairly low key.

In time companies will become more adept at properly explaining their remuneration structures to shareholders which will dampen the current enthusiasm for protest votes.  However I hope that shareholders maintain vigilance.

On that note, it is of critical importance to this whole debate understand what sorts of remuneration structures best incentivise decision making for the long term prosperity of the company, and consequently, the shareholders.

Leading behavioural economist Dan Ariely has conducted numerous experiments on the impact of bonus structures on work performance under controlled conditions, which appears particularly relevant.  Here is a glimpse at some of his findings:

What would you expect the results to be? When we posed this question to a group of business students, they said they expected performance to improve with the amount of the reward. But this was not what we found. The people offered medium bonuses performed no better, or worse, than those offered low bonuses. But what was most interesting was that the group offered the biggest bonus did worse than the other two groups across all the tasks.

More detailed discussion of other results can be found at Dan’s blog.  Similar counterintuitive findings (to the trained economist at least) are emerging from the area of fund management and financial advisory, especially in work by Nobel Prize winner Daniel Kahneman:

For example, he studied the results achieved by 25 wealth advisers, across eight years. He found that the consistency of their performance was zero. “The results resembled what you would expect from a dice-rolling contest, not a game of skill.” Those who received the biggest bonuses had simply got lucky.

Such results have been widely replicated. They show that traders and fund managers across Wall Street receive their massive remuneration for doing no better than would a chimpanzee flipping a coin. When Kahneman tried to point this out they blanked him. “The illusion of skill … is deeply ingrained in their culture.”

So much for the financial sector and its super-educated analysts. As for other kinds of business, you tell me. Is your boss possessed of judgement, vision and management skills superior to those of anyone else in the firm, or did he or she get there through bluff, bullshit and bullying? (here)

It is of utmost importance, therefore, that the sometimes perverse outcomes of performance bonuses, and the role of luck, be considered when exercising this new-found shareholder control.

Globally the corporate world appears to be slowly heading towards a new era of accountability, and Australia is keeping pace with these developments.  I hope that this provides opportunities to better understand the motivational and decision making impacts of bonus payments, and be able to isolate and reward the tough decision that prove beneficial for the company, from the luck that comes from being in charge at the right time in the economic cycle.

Tips, suggestions, comments and requests to [email protected] + follow me on Twitter @rumplestatskin


  1. Thanks Rumples

    For mine, as a small business, I do pay bonuses to staff if we do well. I don’t see it as a bonus so much as just what they are owed for their good work. It’s an ‘after the event’ thing in that the first issue is to stay in business.
    However as far as the performance of the business goes it is of little to no importance. What matters is the pride in what we do and the feeling of a team working together to do it. A happy workplace is part of the latter.

  2. What we need to work out and understand about the modern day concentration of wealth, is, HOW MUCH of it is the result of successful rent-seeking and zero sum wealth transfers, HOW MUCH of it is money made by providing consumers what they want at a fair price, and HOW MUCH of it is money made by the sector of the economy that actually produces rather than consumes wealth?

    I think it is a tragedy that the “rent seeking” escapes scot-free all the time, while the latter two are most often the subject of punitive political action. In fact, politicians almost inevitably play into the hands of the rent-seeking wealth transferring sector even in attempting to ADDRESS inequality (and in any case creating new opportunities for rent seeking is politicians favourite pastime).

    Attempting to address inequality by penalising PRODUCERS of wealth (and often rewarding rent-seekers at the same time), is like “helping the poor” by sawing off the branch of the tree on which they are sitting, just because the producers of wealth were also sitting on it.

    It has been said that the rightful role of “Finance” is to be “handmaiden to industry”. It is a pointer to everything that is wrong in our economies, that the total share of profits made in the economy by the Finance sector, has grown and grown, crowding out the profits made by the productive sector.

    I very much doubt that benefit has flowed sufficiently to honest investors in productive investments, in recent years. I suggest our problem is the “rent” being extracted from the process of wealth creation, by the finance sector.

    “Sharing the Wealth Generated Between Work and Capital and Its Evolution”
    By Remy Prud’Homme, suggests that the returns to investors in things that DO improve productivity is in fact too low most of the time. We need a lot more serious analysis of this type before we start enacting stupid and destructive “policy solutions” to inequality.

    I suggest that urban planning is one of the biggest causes of zero sum wealth transfers in the wrong direction in society.

    I also suggest that taking taxes off the profits of producers BEFORE they are distributed as dividends or drawings, has delivered producers into the hands of the finance sector in so far as the profits so taken away are unable to be used to fund growth. Many businesses that have failed early on while they were growing, would have survived had they had this vital cash flow to fund their increases in stock and debtors.

    • Phil said “It has been said that the rightful role of “Finance” is to be “handmaiden to industry”. It is a pointer to everything that is wrong in our economies, that the total share of profits made in the economy by the Finance sector, has grown and grown, crowding out the profits made by the productive sector.”

      That was the case, but since the deregulation of finance in the Keating years, banks were encouraged to throw away the old “Statutory Reserve Deposit” and ‘Liquid Government Securities” ratios that kept bank lending to around 45% of their holdings. Due to the loss of that safe base, they needed to move into a more profitable and secure sphere of lending – and housing fits that need. It could be argued that it didn’t work in the USA, but they threw away all good lending rules at the same time, and didn’t stick to what had served them so well for decades.

      Phil – how do we encourage banks to re-enter business lending, or do we give up on banks, and encourage other lenders to occupy that space.

      I’m concious of the existence of genuine non bank lenders in the commercial space, but they don’t have the tight knit support that banks enjoy, so it’s all a bit ad hoc and amateurish as an overall group, although some individual companies are very professional.

      What do you see happening in the space being vacated by banks. Do we need regulation, or would that stifle genuine innovation and growth. Seriously the west won’t be able to compete with asia if we don’t get our act together soon.

      • Peter and Phil

        I’m just thinking out loud here so feel free to rip and tear.
        Our problem is much larger than just banks although they are the big duck sitting in the water. Take the Law for example. I’m not an expert but my experiences run in a few directions.
        I’ve been to Courts and watched the way small criminal proceedings are dealt with. The waste is unimaginable…Hearings to set dates for hearings into the smallest of matters!!! I’ve sat in corridors, (expensive)solicitor sitting beside me drinking coffee for hours, waiting for hearing of a matter that we all already agree on.
        In the past when I’ve had leases negotiated the more incompetent the solicitor the more time is spent correcting their work and the more money they charge!!!
        My son has a SIMPLE case before the NSW Supreme Court that has now run for 6 months and cost his side alone $5M. In October the lawyer for his side supposedly worked on his case to 8 hours per day, every day, at $750 per hour. The whole thing is corrupt!!! Top to bottom! Productive enterprises are being bled dry by this sort of stuff every day.

        This extends to a whole range of issues. We now have a Public Service who employ more and more people at higher and higher salaries as see their only job as to introduce more regulation to more and more hamstring productive enterprises. The WHS is totally out of control.
        Yesterday we were told about a change to labeling that will cost us, a small business, tens of thousands of dollars. Yet it will make no difference whatsoever to the warranty on anything we sell! How do such things happen? People sitting around with nothing to do!

        So it’s not just the Bankers. In our society this sort of behaviour is accepted and even worse thought to be clever.
        The damage is irreparable!
        Again the answer lies 50 years back in time.

        • Flawse I have far too much respect for you to ever “rip and tear” and in this case I agree 100%

          I remember have a heart to heart with one solicitor I knew well at the time about the unfair dismissal laws. He said that he refused to work in the “BS” area of law. He had only one success ever, and that was when the other party (the ex employee) leapt across the rail and punched his client in the courtroom. In every other case the court awarded against the employer, simply because they felt sorry for the employee. The point of law is simply completely lost in many of the small courts.

          I have close friends who are solicitors, and they all hate their work with a passion because they have to argue positions, precedents and laws that they completely disagree with.

          Since Federation we must have had millions of laws passed by well meaning politicians that simply glue our economy to the floor, and make us completely uncompetitive. Do you think that all of this BS happened in pre WW2 USA or currently in China.

          I’m not a complete libertarian – we do need sensible regulations, but over regulation is a huge cost to us, perhaps enough to bring the west down in compliance and BS law.

          Stay away from the courts Flawse, they are only for the very rich or dirt poor – everyone else gets screwed.

          • +1

            There is something wrong with British style law – I can’t put my finger on it, I’m definitely no expert (although I started a law degree, I saw the light…), but the adversarial nature (just like Westminster politics, which is a broken system IMO) must be at the heart of it.

            I agree about regulations however – they are destroying the potential of so many SME and innovators/inventors. Coupled with a poor private equity market and willingness to invest in anything other than houses or holes (and how can you blame people otherwise, the way the tax system is set up?), it doesn’t bode well for the future IMO.

          • Prince I’m genuinely pleased that you didn’t complete that law degree.

            The two smartest lawyers that I can think of are Hoagy Carmichael who walked out one lunch hour to became a composer way back in the 1930’s and our very own Anh Do who is one of our most successful comedians – also an ex boat person. Funny how life works.

          • w.r.t to the increasing number of laws:

            The old cliche about is all you have is a hammer everything looks like a nail. Thus the political solution to everything is to legislate and we have exponential growth in our statutes. Imagine the body of legislation that will exist in 100 years, 200 years …FFS!

            The political incentives need to somehow be reconstructed to reduce the quantity of legislation but I am frakked if I know how to do that.

            w.r.t adversarial, I am under the impression that this is mainly an anglo thing?? Is that correct? i.e. our european friends have systems that have evolved with an investigative emphasis?

          • Which is why I contend we need to get rid of popular legislative assemblies.

            Although so-called “anti-democratic”, the ability to endlessly legislate – due to short term pressures from a largely uneducated (or apathetic) electorate – instead of creating meaningful, long term policy, has led us down this road.

            A democracy can only truly work at the town/community level where everyone literally has a say.

            Instead we have a bastardised derivative, as toxic as a CDO, that again, looks all fine and dandy and stable or “moderate democracy” – until it isn’t.

            We need leaders – i.e Senators – not lawyers in government. /rant

  3. A very good topic to discuss on MB and I hope the thread continues overtime.

    As a former bankster, large bonuses were stifling to innovation and encouraged internal and external rent seeking. In the end this is very destructive to both the firm and the individual. If happiness was the measure then excessive bonuses would not contribute.

    My continued observations is that large bonuses are nothing more than score cards to be compared as to who’s the biggest alpha but are deeply dangerous to the organisations and those in them that are truly innovative and care about their jobs.

    Slightly off topic, Rumple do you know of any studies around the value or lack of value of indepemdent directs?

    Deep T

  4. What always puzzles me about bonuses (to senior management) is that some people claim they are improve performance or are needed to keep the best people at the company.

    On the other hand, further down the staff foodchain, management seem to have the view that restricting staff benefits is what is needed to improve company performance.

    Or to put it more bluntly, management need carrots to perform whereas the rank and file need a big stick.

    And we have this furphy about the global rate for CEOs and senior management. Are global head hunters really beating down the doors here to get our managers? And why would senior people want to leave our cozy oligopolies and have to actually perform in a competitive market?

    I really think it is about time companies called the bluff when it comes to the need for pay rises because of how much they can get elsewhere. In other words, “mate if you reckon you can get another X mill in another job, thank you for your service, you leave with our best wishes, goodbye.”

    • Absolutely…but suppose the Head of a big Super Fund goes down the road and votes for a Banker’s trough to be decimated. What would happen to his own package?

        • This is something I would very much like to know, if there are studies and books that I can read up.

          How does the CEO class manage to manipulate things this successfully?

          I have come to believe that one of our problems today is that larger numbers of people than at any other time, have been intelligent and hardworking enough to make money to invest, but they are NOT very clever as “investors”.

    • “I really think it is about time companies called the bluff when it comes to the need for pay rises because of how much they can get elsewhere. In other words, “mate if you reckon you can get another X mill in another job, thank you for your service, you leave with our best wishes, goodbye.””

      That’s probably why the chairman of Watpac went off. How dare the owners of the business hold him accountable.

  5. I think that in addition to these bonuses being scores to compare with others, the large amount makes it worthless to try and work better. If doing well means you get 20 million and poorly means 15 million.. really who cares? You can buy your 10mil yacht either way. But bring it down to low single digits and limitations to what you can buy start to appear.

    • I’ve seen this a while ago and agree that it is well worth a look. It certainly suggests there might be some science behind the title of this article.

  6. Sorry to those who have read this before.

    A couple of years ago 4 Corners or some such did a story on teh manager of a Korean ship yard. These guys are turning out a Super Tanker a week or some such! The head of the company started out as a welder.
    They asked him how much he earned and his reply was USD$240,000 per year. The interviewer commented that it didn’t seem much for a head of such a large operation. His reply was that it was a good and he was very happy with it!!!

    Big difference to Gail Kelly, and all the rest, here!

    • How about limiting the total remuneration of the highest paid person to no more than 100x the lowest paid. Hard to argue that’s unfair.

      • This has got me thinking.

        Tie it to the MEDIAN remuneration in the company, and you have my vote. Your method would just result in the shedding of low paid staff, and the contracting out of low paid functions.

        Also, make it obligatory that a “bonus” to a CEO has to be matched by a “bonus” of the same proportion, to every employee in the company.

  7. One of the worst rackets today, is the result of the fact that “quantitative easing” is all done VIA THE BANKS and the Finance Sector.

    Read THIS:

    “The Real Housewives of Wall Street” by Matt Taibbi


    What is the difference between this, and Robert Mugabe and his mates being the first to spend the newly printed Zimbabwean currency, while the downside effect, the debasement of the currency, is suffered by everyone else further down the money cycle?

  8. The odd thing about this question is that the psychologists’ research suggests that random bonuses are more likely to motivate workers.